An investor who wishes to put funds into a mutual fund, that is buy shares of the mutual fund, typically pays the share price as of the end of the trading day for the mutual fund. Similarly, when an investor wishes to redeem funds, that is sell shares in the mutual fund, the share price is typically determined at the end of the trading day. Since the closing price is the price at which the transactions occur, determining the share price of the mutual fund at the close of the trading day is of great importance.
U.S.-based mutual funds with underlying assets that are traded on foreign exchanges typically use the closing prices of the foreign assets on the foreign exchange to determine the share price of the mutual fund. U.S.-based mutual funds typically determine the price of the fund at 4:00 PM Eastern time. Since the trading of the underlying assets of such a mutual funds close at different times than the mutual fund, the closing price for the foreign asset may not accurately reflect the value of the underlying assets of the mutual fund at 4:00 PM Eastern time. This may result in the mutual fund being under-valued or over-valued. The closing price of an asset is said to be “stale” when it no longer reflects the current value of the asset. The problem of using stale prices for underlying assets is more pronounced in volatile markets.
Arbitrageurs often take advantage of mutual funds that use stale pricing at the expense of other investors in the mutual funds. Arbitrageurs will buy shares of funds when the fund is undervalued and sell the shares when the fund is overvalued. Some U.S.-based mutual funds with underlying assets that are traded on foreign exchanges have attempted to limit such dilution by imposing higher short term trading fees, limiting the number of trades in a period of time, and blocking execution of some trades. These measures prevent only some of the dilution.
Stale prices may occur in other situations. Mutual funds may include assets that are normally traded during the same hours as the mutual fund but for some reason are not traded during a portion of a particular day. For example, thinly traded U.S. securities may have large periods of time when no shares are traded. The last trade of the day for such a stock could be an hour or more before the price of the mutual fund is determined. A stock may not trade for other reasons including: the trading in a stock may be halted for one of many reasons, including, the trading range maximum has been reached; a natural disaster may close an exchange; the trading in a stock may be halted for only individual investors, while other investors can continue to trade; or a stock exchange may be closed for a holiday.